Modern Portfolio Theory and Investment Analysis, 9th Edition

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Behavioral Finance, Investor Decision Making, and Asset Prices

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic.

—John Maynard Keynes, General Theory of Employment, Interest, and Money (1936)

Most of the chapters in this book are normative—that is, they are concerned with how investors should make choices. In practice, however, many people make suboptimal economic or financial decisions. For many reasons it is useful to understand how and why this happens. First, and most importantly, such knowledge can help to improve future decision making. If there are a few basic mistakes that investors make repeatedly, it may be possible through education, training, and communication to reduce or eliminate these tendencies. Second, to the extent that certain forms of behavior are pervasive in the market, they may influence security prices. In the first section of this chapter, we discuss the theory and evidence about investor psychology and behavior and the possibility that these phenomena may play a role in investor decision making. In the second section, we examine whether investor psychology actually influences asset prices.

PROSPECT THEORY AND DECISION MAKING UNDER UNCERTAINTY

The central challenge to investors is the problem of decision making under uncertainty. ...